1031 Reverse Exchanges: Everything You Need to Know
Timing is everything when it comes to making a good property investment, and sometimes a deal on a commercial property is too good to pass up. Seasoned property owners and investors know this, but they also know that it’s not always possible to sell a current property before taking ownership of another.
When this is the case, smart investors turn to companies to help them structure a 1031 reverse exchange.
What is a 1031 Reverse Exchange
A 1031 reverse exchange is a tool that allows real estate investors to acquire a new property before relinquishing control over a current property and utilizing the exchange proceeds. Whereas a traditional 1031 exchange requires investors to sell a property first, reverse exchanges allow them to hold onto a property and sell it later.
Reverse exchanges are a smart way to minimize the price you pay for a new property while maximizing the price you receive when selling your current property. If you own a commercial property, such as a multifamily home, but do not want to sell it right away because of market conditions, you will be able to hold onto it while investing in another property with a reverse exchange. It’s a beneficial process for when property values are low, favoring buyers over sellers.
How You Can Setup a Reverse Exchange
In order to structure a 1031 reverse exchange, one of the properties (either the current or new property) will have to be transferred to an exchange accommodation titleholder (EAT). The EAT is created as a limited liability company (LLC) for the purpose of taking control over the property for tax purposes. The IRS will recognize that the taxpayer (the investor) is not the holder of the property.
Not every investor will be able to setup a 1031 reverse exchange. In order to take advantage of this process, you will need a substantial amount of capital to purchase the new property. This is because you will be unable to access the capital you have tied up in your existing property. If a loan is to be acquired, the money must be lent to the EAT.
There are two ways to structure a reverse exchange:
#1: Parking the Replacement Property
This is the most common type of reverse exchange. In the first phase, a third-party lender or Exchanger grants the EAT a loan to purchase and acquire the title to the replacement property. The EAT then leases the property to the Exchanger under a triple net lease, allowing the Exchanger to reap the benefits and shoulder the burdens of the property.
In the second phase, once the Exchanger sells the relinquished property, the title is transferred to the buyer through direct deeding. The proceeds from the sale go directly to the Qualified Intermediary, who uses the funds to acquire the replacement property from the EAT. The EAT then repays the Exchanger for the initial loan and uses the remaining funds towards the loan given by the third-party lender for the replacement property. If the funds acquired from the sale of the relinquished property are more than those needed for the Qualified Intermediary to obtain the parked property, the Exchanger may identify an additional replacement property within 45 days of the transfer of the relinquished property. They must also complete the additional acquisition within 180 days of the transfer of the relinquished property.
Additional method: If the Exchanger can pay for the replacement property, either due to financing through the seller or a loan from an institutional lender, another type of reverse exchange can be structured. In this scenario, the EAT may be required to be the borrower of the loan. The Exchanger will have to get approval from the lender before beginning the reverse exchange because the lenders may not be familiar with the reverse exchange process. In some cases, the loan costs may be increased. Also, the EAT will likely require the loan to be non-recourse in order to protect itself in the event that the Exchanger goes into default.
#2: Parking the Relinquished Property
The second reverse exchange option involves parking the relinquished property with the EAT. In the first phase of this situation, the EAT takes the relinquished property and is subject to the existing third-party financing as well as a purchase money loan from the Exchanger. The loan from the Exchanger should be equal to the equity the Exchanger has in the relinquished property in order for the it to be considered a fully deferred exchange.
The in next phase, a simultaneous exchange takes place between the Exchanger, the EAT, the party selling the replacement property and the Qualified intermediary. During this exchange, the Exchanger hands over the relinquished property to the EAT and receives the replacement property from the seller. These transfers occur at the same time through the Qualified Intermediary using direct deeding. During the process, the EAT uses funds loaned by the Exchanger to pay for any closing costs. Any leftover funds are then used towards the purchase of the replacement property.
In the final phase, the proceeds from the relinquished property go to the EAT and are used to pay off third-party debt and then repay the Exchanger for the given loan.
Who Can You Contact?
There are many capital partners who can help you setup a 1031 reverse exchange, and Brown Multifamily advisors can help direct you towards companies who can help you with the process. If you are looking for commercial properties for sale in Ohio, get in touch with our team to find out what’s available in your area.
Disclaimer: this information is for general use and is not intended to be taken as specific tax or investment advice. It is advised that you contact a tax attorney or investment advisor directly for specific advice regarding your case.